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Be careful — you might consent to adjudication in bankruptcy court even if you’ve expressly said you don’t

Parties in interest in bankruptcy cases have spent the last four and half years (and perhaps beyond) trying to figure out just what matters can be heard and/or decided by bankruptcy courts. Indeed, there has been no shortage of litigants’ efforts to use the nuances of civil procedure and constitutional law to obtain a strategic advantage over their adversaries in bankruptcy court. We thought we had some degree of clarity when the Supreme Court concluded that bankruptcy courts can enter a final judgment in Stern and non-core matters, so long as they had the parties’ “knowing and voluntary” consent, which could be implied from the parties’ conduct. We thought we knew what that meant. We may have thought wrong. A recent decision from the United States Bankruptcy Court for the Middle District of Alabama suggests that this “consent” thing might be even more complicated that it appears to be.

The decision originated in a contract between Sleepy’s and Professional Facilities Management, Inc. (“PFMI”), pursuant to which Sleepy’s paid PFMI for HVAC and related maintenance services at approximately 800 Sleepy’s retail stores. PFMI subsequently filed a chapter 11 petition, after which its bankruptcy case was converted to chapter 7. The bankruptcy court set a bar date for claims against PFMI, which passed in February 2015. Three months later, PFMI’s chapter 7 trustee commenced an adversary proceeding against Sleepy’s in the bankruptcy court, seeking to collect an account receivable of approximately $1.1 million. The trustee’s complaint asserted claims for account stated, breach of contract, and quantum meruit for unpaid work allegedly performed for Sleepy’s. In response, Sleepy’s asserted counterclaims against PFMI for nearly $2 million in damages allegedly suffered due to PFMI’s failure to pay its subcontractors and to perform preventive maintenance in Sleepy’s stores. Sleepy’s further demanded a jury trial and wrote that it did not consent to a final adjudication in the bankruptcy court.

The chapter 7 trustee moved, among other things, to strike Sleepy’s jury demand, arguing that (i) her claims were core proceedings pursuant to 28 U.S.C. § 157(b)(2) and (ii) Sleepy’s counterclaims effectively acted as a proof of claim against PFMI and therefore constituted implied consent to a final judgment in the bankruptcy court. Sleepy’s objected, contending that (i) the claims before the bankruptcy court were not core and were therefore outside the bankruptcy court’s authority to enter a judgment without the litigants’ consent and (ii) Sleepy’s had expressly refused to consent to adjudication in the bankruptcy court and could not be compelled to proceed there over its express objection.

Core or Non-Core?

In the first instance, the bankruptcy court concluded that the trustee’s claims were not, in fact, core. Specifically, the court concluded that claims to collect accounts receivable and contractual claims to turn over disputed property are not core matters because they are not, in themselves, matters concerning the administration of the estate, rendering § 157(b)(2) inapplicable. Moreover, citing to the decision of the Eleventh Circuit Court of Appeals in Cmty. Bank of Homestead v. Boone (In re Boone), the court noted that the trustee’s claims “do[] not affect the contract[] that give[s] rise to their debtor-creditor relationship” and thus “do[] not ‘adjust’ the debtor-creditor relationship in any way.” Because the trustee’s claims were all “state law claims that do not invoke a substantive right under the Bankruptcy Code and that could have proceeded in state court had there been no bankruptcy[,]” they were non-core and could not proceed to judgment in the bankruptcy court, absent the litigants’ consent.

Did Sleepy’s Actually Consent Even Though It Expressly Withheld Consent?

Turning, then, to whether the claims and counterclaims could proceed to judgment in the bankruptcy court, the bankruptcy court looked to the Supreme Court’s recent decision in Wellness Int’l Network, Ltd. v. Sharif. InWellness (discussed at length in Well Well Wellness: The Supreme Court’s Most Recent Decision Regarding Stern v. Marshall and its Progeny), the Supreme Court concluded that bankruptcy courts may adjudicate “Stern” claims and non-core proceedings if the parties expressly or implicitly consented to same. And even though such consent may be express or implied, it must be “knowing and voluntary.” In particular, such consent would permit the bankruptcy court to issue a judgment on any such claims and counterclaims, even if a Seventh Amendment right to a jury trial would ordinarily attach to those claims.

How, then, can consent be implied from a litigant’s conduct?

One frequent scenario in which a creditor is deemed to have consented to adjudication in the bankruptcy court is where the creditor has filed a proof of claim against the debtor in the bankruptcy case. Extensive Supreme Court precedent supports the conclusion that in those cases, by opting into the bankruptcy case by filing a proof of claim, the creditor has submitted to the bankruptcy court’s equitable jurisdiction not just for the claim that it filed, but also for any counterclaims or defenses that the debtor might assert in response, insofar as those counterclaims would necessarily be resolved in the claims allowance process. Some courts have extended this principle to scenarios where the debtor or trustee initiates an action against a defendant and the defendant then asserts a counterclaim against the debtor—in those circumstances, the defendant is deemed to have consented to the bankruptcy court’s equitable jurisdiction even with respect to the debtor’s affirmative claims insofar as such claims would necessarily be resolved in ruling on the creditor’s (later-asserted) counterclaims against the debtor’s estate.

Cutting to the heart of the issue, the bankruptcy court drew a distinction between counterclaims seeking tonegate the debtor’s claim and counterclaims seeking affirmative recoveries from the debtor. Where the defendant is simply seeking to defeat the debtor’s claims (i.e., reduce them to $0, via setoff or otherwise), it might argue that it has not consented to adjudication in the bankruptcy court. But where the defendant seeks a net recovery from the debtor, its counterclaims are tantamount to filing a proof of claim against the debtor.

In PFMI’s case, Sleepy’s had not filed a proof of claim prior to the claims bar date. However, because Sleepy’s demanded nearly twice as much money as PFMI’s trustee asserted against Sleepy’s in her complaint, the bankruptcy court concluded that Sleepy’s had asserted a (late) proof of claim against PFMI. The bankruptcy court was not moved by the fact that Sleepy’s affirmative claims (if successful) could conceivably be barred due to the fact that it was not timely filed. Even though the claim was late, it should not be excluded from the types of claims that can give rise to a waiver of a jury trial (and to consent to the bankruptcy court’s adjudication) because even late claims could conceivably receive a distribution (for example, if the claims are excepted from the debtor’s discharge, or if the court determines that the claim was late due to excusable neglect). Accordingly, the bankruptcy court concluded, “[t]he mere possibility that Sleepy’s might receive a distribution on its untimely claim is sufficient to submit the claim to this Court’s adjudication.”

Finally, the bankruptcy court acknowledged that Sleepy’s could have avoided its loss of a jury trial and/or adjudication outside the bankruptcy court. For example, if Sleepy’s and PFMI had agreed to arbitrate or to a forum selection clause, Sleepy’s could simply have moved to enforce those clauses. Alternatively, Sleepy’s could have moved the bankruptcy court to abstain from hearing the proceeding to allow a state court to resolve the claims. Or Sleepy’s could have moved the district court to withdraw the reference to the bankruptcy court. The bankruptcy court, then, appeared to lack sympathy for Sleepy’s because it “had all of these options except arbitration at its disposal, but chose not to exercise them.”

Looking more closely at the decision in favor of PFCI, it is particularly interesting that the bankruptcy court emphasized the determinative fact that Sleepy’s had asserted counterclaims against PFMI in excess of the trustee’s claims against Sleepy’s, and that those affirmative claims were “akin” to a proof of claim against the debtor, which therefore constituted knowing and voluntary (implied) consent to adjudication in the bankruptcy court and waiver of Sleepy’s right to a jury trial. It seems, then, that it may not be sufficient for defendants and counterclaimants to affirmatively withhold their consent to having their claims heard and decided in bankruptcy court, without a jury trial. According to the Alabama bankruptcy court, they should clearly and unequivocally state that they waive any and all affirmative recoveries from the debtor’s estate. And woe to the litigant who fails to note accordingly in his or her pleadings and must seeks to correct the mistake at a hearing before the bankruptcy court!

Compare jurisdictions: Arbitration

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